As UBS boss quits over rogue trader, banks must face some risk realities

Author

Professor of Accounting, Banking and Finance at University of Canberra

Disclosure statement

Milind Sathye does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.

The chief executive of Swiss banking giant UBS, Oswald Gruebel, has quit following revelations of a $US2.3 billion fraud by “rogue trader” Kweku Adoboli. But the news will come as cold comfort for investors, shareholders and employees.

These are the people who will be most severely affected by this manifestation of UBS’s faulty risk-management practices, and indeed, the failure of investment banks around the world to ensure traders are not allowed to make dangerous bets with other people’s money.

It was an amusing coincidence that the UBS scandal came closely on the heels of the release United Kingdom’s Independent Commission on Banking report.
One of the major recommendations of the report was that banks should be forced to “ring-fence” retail banking from “casino” banking.

This recommendation, which drew vehement opposition from some quarters, aims to ensure depositors on the retail side of a bank are insulated from risky positions the investment side of the bank may take.

But is ring-fencing and tighter regulation really the answer to the lax risk-management controls at banks?

Over the years, banks appear to have become over-reliant on technology. The age-old wisdom of manual checking and cross checking has nearly disappeared.

After the Jerome Kerviel scandal broke in 2008, causing a $US7.7 billion loss for Societe Generale, the bank admitted that although controls existed, they were not cross-checked – something that needs to be done manually.

Nick Leeson, who brought about the collapse of Barings Bank in 1995 through fraudulent trades, says on his website that “not enough focus goes on those risk management areas, those compliance areas, those settlement areas, that can ultimately save them money”.

Big scandals make news and for a moment there is a flurry of activity. Assurances of tighter controls and better surveillance are routinely given. Then everything is forgotten until another, bigger scandal surfaces.

Delta One desks

Both Kerviel and Adoboli worked on “Delta One” trading desks at their respective banks. These desks are generally considered to be low-risk, making quick gains by spotting arbitrage opportunities in the market.

They do this by taking opposite positions in the market on two investments of comparable value. In one, they go “long” by betting the value will go up, say, within a month. In the other, they go “short” by wagering the value will go down.

They make money by continually taking advantage of the price differential during the duration of the futures contract. Kerviel and Adoboli became adventurous and appear to have not covered their bets. Instead, they allegedly created synthetic accounts that made it look like counter bets were made.

The crux of the matter is that neither Societe Generale nor UBS had any means of finding out whether a trader was exposing the bank to undue risks. A lack of manual cross-checks was at the heart of the problem.

The trouble with bonuses

But what are the incentives for traders to make
such risky bets?

Traders get hefty bonuses for the profits they generate from the trades they make.

These incentives push them to take undue risks or enter in to unauthorised transactions. If you are a computer wizard like Adoboli then you have a further advantage – you can cover your tracks undetected. It has been reported he successfully evaded detection for three years.

The extent of the lure of compensation could be gauged from the fact that in the years running up to the financial crisis of 2008, investment banks spent nearly half of their revenue on compensation packages.

Little has changed since, and such incentives make bank customers and shareholders vulnerable to considerable risk.

If incentives are the trigger for such behaviour and bank management know it, then the question is: what are they doing about it?

One would expect fragile risk management systems to be detected by audits of internal controls of banks. But when banks are in a hurry to make money and boost revenue, caution is thrown to the wind.

By the time a scandal surfaces, the managers have moved on or retired.

The US Financial Crisis Inquiry Commission (FCIC), set up after the collapse of Lehman Brothers, concluded: “These pay structures had the unintended consequence of creating incentives to increase both risk and leverage, which could lead to larger jumps in a company’s stock price”.

Ask any risk manager and he or she will tell you how hard it is to get budget for improved risk controls. Focussing on risk does not earn revenue for a bank, so it is generally management’s lowest priority.

Short-sighted regulation

But why haven’t auditors and regulators detected that banks are lax when it comes to risk management?

A certain amount of complacency has set in regulatory systems in the world’s biggest economies. Auditors and regulators rely on what banks tell them without taking the trouble of examining and applying scepticism to that information.

The FCIC found the US Federal Reserve endorsed risk-taking by banks, while labelling it “modernisation”. The Fed believed “financial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management”, and so did regulators everywhere – exposing depositors and investors alike.

Bank customers and investors have little time to monitor banks – they are occupied with making a living and working hard.

They believe auditors and regulators are doing the job for them and there is nothing to worry about. That is, until a scandal such as the one at UBS comes to light.

The claims banks make about their risk management system are obviously hollow. Banking works on trust, and to maintain this, banks have to keep saying their risk management systems are “state of art”.

In Australia, public memory is short. National Australia Bank suffered losses of $360 million in 2004 on currency options desk. Questions about its risk management practices also came into question when it suffered a loss of $4 billion in US HomeSide in 2001.

Yet there has been very little effort to improve risk management practices at Australian banks in the decade since.

The collapse of Storm Financial – which was blamed on margin lending desk at the financial advisor – is a reminder risk management practices in Australian banks need further improvement.

The Adoboli affair is a wakeup call for banks, auditors and regulators around the world.

Australia’s banks and regulators must ensure this scandal become more than just a good news story – it should force our banks to thoroughly assess their risk-management practices.